Reducing Your Tax Burden in Retirement

November 1, 2016

In the years leading up to retirement, too many people overlook opportunities to reduce their tax liability. Whether you are working into your 70s or retiring in your 50s, simple strategies executed at the right time can cushion your retirement funds and ensure you have the flexibility to maintain your lifestyle through your retired years.

Account for your RMDs
Many people who plan to work past age 70 consider rolling their 401(k) into an IRA once they’re within a few years of retirement. They often do this thinking they can enjoy continued tax-deferred growth in a more flexible vehicle, with more investment options.

However, once you reach age 70.5, you will be subject to required minimum distributions (RMDs) from that IRA. You’ll need to withdraw a minimum amount from your balance by the end of each year, and pay the taxes on those funds. Qualified employer-sponsored retirement plans allow you to delay mandatory withdrawals until the year after you retire, which is why in certain situations we advise clients who are older and still in the workforce to stick with their 401(k)s for as long as they can.*

Navigating these investment vehicles was the challenge facing one client who engaged Wescott five years ago. He was an attorney in his late 60s, unsure of when he was going to retire. He had a significant balance in his employer-sponsored plan, and was inclined to do an in-service rollover into an IRA to secure better investment options.

In discussing his future career plans, however, we learned that he intended to work for at least three to five more years. If we rolled his retirement funds into an IRA, he would be subject to RMDs beginning at age 70.5 while still earning a salary that provided him with enough cash flow—significantly increasing his annual income and tax liability.

So we began looking into other options, starting with his firm’s human resources department. We learned they also offer a self-directed plan, which would allow our client to open an account with another custodian and access more investment options. It was still within his employer’s qualified plan, so even though he is now past age 70.5, he is not subject to RMDs.

By thoroughly investigating all options available to our client, we helped him identify a flexible retirement savings vehicle while also avoiding a sharp income increase that would have created a severe tax burden in his 70s.

Keep a finger on your tax bracket
It’s critical to understand your tax bracket during your working years and during retirement. Your wealth may fluctuate throughout your life, providing opportunities to strategically take advantage of tax minimization strategies.

In particular, individuals who retire before their RMDs take effect at age 70.5 should closely monitor their marginal tax bracket. If they experience a lower-income period, they may be able to withdraw funds from their retirement accounts at a lower tax rate.

As an example, several years ago a client came to us to discuss the most tax-efficient way to fund her retirement. She retired in her mid-50s with a large IRA and a substantial personal account. At the time, her only source of cash flow was from her investment portfolios. And while this could have funded her needs until her RMDs began, we didn’t want to deplete her personal investment assets over those 15 years. By the time she reached her 70s, nearly 100% of her net worth would have been tied up in her IRA—and she would be dependent on taxable distributions from her IRA to fund her retirement cash flow needs from that point on.

We wanted her to have more flexibility in retirement, so we kept a pulse on her marginal tax bracket. Over a seven-year period, we ran annual projections to determine her taxable income. She was in a “sweet spot”—during this lower-income period in her early retired years, she dropped down in her marginal tax bracket. So we began withdrawing funds from her IRA each year, nearly or completely tax-free.

A few other factors worked in her favor. Because she retired early, she did not yet have Social Security contributing to her income. She also happened to be charitably inclined, so she had large charitable deductions that offset her taxable income.

By capitalizing on fluctuations in our client’s tax bracket, we were able to achieve significant tax savings and ensure her personal investments would last well into retirement.

* Note that this is only applicable to individuals who own less than five percent of their company; business owners and those who own more than five percent are subject to minimum distributions beginning at age 70.5 regardless of working status.

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